Valuation of inventory
Basic rule
The valuation of inventory can be extremely important for financial reporting, because the valuations affect both the cost of sales (and profit) and also total asset values in the statement of financial position.
Inventory must be measured in the financial statements at the lower of:
Inventory must be measured in the financial statements at the lower of:
- cost, or
Net realisable value is the amount that can be obtained from disposing of the inventory in the normal course of business, less any further costs that will be incurred in getting it ready for sale or disposal.
- Net realisable value is usually higher than cost. Inventory is therefore usually valued at cost.
- However, when inventory loses value, perhaps because it has been damaged or is now obsolete, net realisable value will be lower than cost.
The cost and net realisable value should be compared for each separatelyidentifiable item of inventory, or group of similar inventories, rather than for inventory in total.
Cost formulas
With some inventory items, particularly large and expensive items, it might be possible to recognise the actual cost of each item. In practice, however, this is unusual because the task of identifying the actual cost for all inventory items is impossible because of the large numbers of such items. A system is therefore needed for measuring the cost of inventory.
The historical cost of inventory is usually measured by one of the following
methods:
The historical cost of inventory is usually measured by one of the following
methods:
- First in, first out (FIFO)
- Weighted average cost (AVCO)
The weighted average method calculates a new average cost per unit after each purchase. This is then used to measure the cost of all issues up until the next purchase.
Inventory and drawings
The owner of a sole trader business might decide to take some inventory for his
or her personal use. For example, the owner of a local shop might take some of
the goods bought for the shop and use them for personal consumption.
When this happens, it is important that the financial statements of the sole trader
should provide a faithful representation of the financial performance of the
business. In order to achieve this objective:
or her personal use. For example, the owner of a local shop might take some of
the goods bought for the shop and use them for personal consumption.
When this happens, it is important that the financial statements of the sole trader
should provide a faithful representation of the financial performance of the
business. In order to achieve this objective:
- Drawings by the business owner in the form of inventory should be accounted for as drawings (withdrawals of capital).
- The cost of sales should exclude the items taken by the owner as drawings.
Drawings of inventory might be common in small sole trader businesses, but are less common in bigger business entities, where stricter controls over inventory might be considered necessary. Small businesses normally use the period-end inventory system, and when the owner takes some inventory for personal use,
the appropriate accounting entry in the main ledger is:
the appropriate accounting entry in the main ledger is:
Illustration: Purchases through the year
Debit Credit
Drawings X
Purchases X
The inventory taken by the owner is valued at cost (not selling price). This accounting adjustment therefore reduces the total cost of purchases, so that the cost of sales will exclude the cost of the inventory taken.
If a perpetual inventory system is used, the appropriate accounting entry would be:
Drawings X
Purchases X
The inventory taken by the owner is valued at cost (not selling price). This accounting adjustment therefore reduces the total cost of purchases, so that the cost of sales will exclude the cost of the inventory taken.
If a perpetual inventory system is used, the appropriate accounting entry would be:
Illustration: Purchases through the year
Debit Credit
Drawings X
Inventory X
Drawings X
Inventory X
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